When comparing two different products, you may just want someone to tell you which one is the best option so you can buy it and move on with your life. However, when it comes to debt products, such as personal loans versus lines of credit, the best option varies from person to person. That’s why you need to understand the advantages and disadvantages of each option, so you can choose wisely.
If you are choosing between a personal loan and a line of credit, we have you covered. Here’s what you need to know about each of them.
Related: Compare personal loan rates
What is a personal loan?
A personal loan is a financing method that you can use for a variety of expenses, such as remodeling your home, paying for a wedding, or combining high-interest credit cards. They are usually unsecured, which means that there are no collateral backing the loan.
The best personal loans usually have limits between $1,000 and $100,000, depending on the lender and your creditworthiness. You will receive your financing as a lump sum and pay it back in fixed monthly installments, usually for a period of between two and seven years.
When to choose a personal loan?
Various types of personal loans are commonly used to cover expenses such as emergencies, unexpected bills, home improvement projects, auto repairs, and even debt consolidation. You should get a personal loan when you are sure of the amount you will need to borrow.
For example, if you know you need to borrow $20,000 to attend a wedding, choose a $20,000 Personal Loan. If you’re not sure how much you’ll need and have a ballpark number, a line of credit may make more sense.
What is a line of credit?
A personal line of credit is more like a credit card than a personal loan. When you apply for a line of credit, the lender agrees to you a certain amount, usually up to $100,000 with some lenders offering up to $500,000. Instead of receiving the amount as a lump sum, you can withdraw to that amount on an as-needed basis. You pay interest only on the amount you borrow, and you will pay off your balance in fixed monthly payments.
When to choose a line of credit
A line of credit is a solid choice if you want more wiggle room and a fund for rainy days to pay for occasional expenses. Common uses include emergency expenses, long-term projects, education expenses, cash flow management, and debt consolidation.
Since you will receive a limit rather than a lump sum of money, you can use as much or as little of the limit as you want. For example, if you open a line of credit with a limit of $30,000, you can only use all or part of the $30,000.
Personal Loan vs Line of Credit: Key Differences
The limits on unsecured lines of credit are higher than on personal loans. While some banks offer limits up to $100,000, you may find some lines of credit as high as $500,000. The maximum amount available for a personal loan is usually between $50,000 and $100,000.
Personal loan interest rates are usually fixed and range from 3% to 36%. Rates are set based on your credit eligibility, which means if you have good credit and steady work, you can get a better rate. However, if your score is damaged, expect to get an average at the higher end of the range.
Conversely, a line of credit usually has a variable interest rate, which fluctuates based on the base rate. If the base rate of interest increases, the rate of interest on the credit line will also increase. Borrowers can expect rates of at least 10%.
Lenders may charge an origination fee when obtaining a personal loan, typically between 1% and 8%. Try to find a lender with the lowest set-up fees, or no lender if possible.
On the other hand, an unsecured line of credit may include an annual fee during the withdrawal period. These fees are usually $100 or more. Some lenders will waive fees for the first year.
Both financing methods usually charge a late payment fee.
Minimum Credit Score Requirements
Lenders often have higher credit score requirements for lines of credit than personal loans. For example, borrowers must aim for a credit score of at least 670 when applying for a line of credit. However, there are personal loans available that only require a score of at least 580. Keep in mind: a higher credit score can give you more favorable terms.
Most personal loans have terms between two and seven years, and repayment begins once the lender disburses the money.
On the other hand, a line of credit has two separate periods: the withdrawal period and the repayment period. During the withdrawal period, which is usually five to 10 years, borrowers can reach the credit limit up to the maximum, and they are required to make minimum payments.
When the withdrawal period ends, the payment period begins. During this time, which varies depending on the lender, borrowers will not be able to withdraw funds from the credit line and must repay the outstanding loan principal and accrued interest on a fixed date specified in the loan agreement.
When you start taking out a personal loan, the repayment starts immediately and continues until the loan is paid off in full. However, with a line of credit, you will make the minimum payments during the withdrawal period and pay off the remaining balance (including interest) during the payment period. If you do not withdraw any money, you will not have any payments.